The Influence of Domestic and Foreign Shocks on Portfolio Diversification Gains and the Associated Risks

Abstract

This paper evaluates the influence of foreign or domestic stock market return and return of volatility shocks on dynamic conditional correlations (DCCs) between international stock markets and correlation volatility, respectively. The correlations between markets have implications for the gains from portfolio diversification, while correlation volatilities can be seen as risks to portfolio diversification. Meanwhile, domestic shocks are sourced from the return and return volatility from 24 developed, emerging, and frontier stock markets. The US stock market is the source of foreign shocks. The domestic and foreign shocks are derived using market-based returns and under bearish market conditions. We estimate multivariate exponential generalized autoregressive conditional heteroskedasticity (E-GARCH) models using daily and monthly MSCI based stock price data of selected developed, emerging, and frontier markets over 1993:1–2014:1. Our key results are as follows. Domestic market shocks were significant drivers of gains from portfolio diversification most of the time, although the US market effects were relatively stronger. On the other hand, the US, in terms of the number of significant cases as well as the size effects of shocks, dominated as a determinant of correlation volatility (or risks to portfolio diversification). Further, under bear market conditions, adjustments in correlations and correlation volatilities are found to be mostly US-induced. Bearish shocks, rather than market return based shocks, show strong evidence of the leverage effect. Signs of persistence of shocks are mainly noticed under bearish conditions.

Econophysics Techniques and Their Applications on the Stock Market

“…Herzog and Osamah (2019) [28] use a reverse engineering approach in order to determine option pricing and suggest that their approach is highly significant in establishing important future research directions. The impact of portfolio diversification has an effect on domestic and foreign stocks, suggesting that there is a significant impact of correlation volatilities and risks associated with a diversified portfolio (Nayan, 2019) [29].…”

Asian Current Account Balances and Spillovers From a Foreign Country, a Region and the United States

“…We discuss the implications of these engagements on the current account in Section 2.3 For trade, see for example,Narayan (2019);Narayan and Nguyen (2015;2019); andNarayan and Bui (2019). For studies on financial integration, seeWӓlti (2011);Longin and Solnik (1995);Narayan et al (2014);Narayan and Rehman, (2017;2018;2019).…”